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It’s a Wonderful Bank Run

We all remember that famous scene in the James Stewart movie,”It’s a Wonderful Life” where Stewart’s character, George Bailey, is trying to calm a panicking crowd in his Building and Loan. It would have it that the film’s evil character, Mr. Potter had started a rumor that Bailey’s Building and Loan was “illiquid”, that it didn’t have the cash on hand to cover withdrawals. Potter was right. Your money’s not here, George explained to the angry crowd. “Your money is in Joe’s house… And in the Kennedy’s house, and Mrs. Macklin’s house, and a hundred others…”

Although the Building and Loan were asset rich, it was cash poor. It was unable to meet the heightened demand of mass withdrawals that the panic driven bank run had induced. It wasn’t insolvent, it was simply not able to translate capital into cash quickly. The fear of a bank run was always present in any banker’s sub-conscience. It was the best way to keep risky lending to a minimum. But that all ended with deposit insurance and central banking.

The Moral Hazard

During the doldrums of the Great Depression, Congress passed the Banking Act of 1933 which also created the Federal Deposit Insurance Corporation (FDIC). The intent was to stem off any future bank runs by the general public by ensuring all deposits up to $2,500. Insurance limits were continually being increased over time. Today, the FDIC claims to insure deposits at some 6,638 institutions up to $250,000 for each ownership category.

By having the government insuring depositors at banks, removed that ever persistent fear of a run on the banks. It also introduced “moral hazard” into banking like never before. The public no longer concerns themselves with choosing a well-grounded banking institution to do business with. As long as that FDIC emblem is stuck on the door, all is fine in the public’s mind. It also releases unscrupulous bankers from being diligent with their deposits. Now, speculation replaces diligence.

To make matters worse, since 2013 the FDIC is now backed by “the full faith and credit of the United States government”. In other words, if the federal government so chooses under Title IX, it can call upon the Treasury through the Federal Reserve Act to bail out the fund. Which brings into question, just how well funded is the FDIC anyway?

Back when the Federal Reserve was only a glimmer in J.P Morgan’s or John D. Rockefeller’s eye, in 1873 an English businessman named Walter Bagehot devised a plan to ensure the solvency of central banks and inject some semblance of discipline into banking. In times of crisis, central banks were expected to follow Bagehot’s Rule which can be summarized as: “Lend without limit to solvent firms, against good collateral, at high rates.” The idea was to lend to a solvent firm, like Bailey’s Building and Loan, that was asset rich but cash poor, preventing the firm from having to liquidate. Over time, the loan to the central bank could be paid off at a punitive rate and the bank could remain standing. Having learned the penalty of being illiquid, this established the idea that the central bank should be the lender of last resort. This had been, more or less, the norm in central banking. So it was until the term, “too big to fail” crept into our vernacular.

Regardless if deposit insurance or central banks are present, the underlying moral hazard that plagues every lending institution is fractional reserve banking. Because only a fraction of deposits is on hand at any given time, the hazard of a loss in confidence by depositors in a bank’s ability to meet cash demands calls for such interventions as deposit insurance or Bagehot’s Rule. Moreover, the entire world banking system is based on this fraud. It is no surprise that crashes, panics, recessions and depressions rear their ugly heads from time to time. Like the little Dutch boy plugging the holes in the dam, the world’s financial system is springing leaks all of the time and all over the place. Each crisis calling for more regulation or intervention that removes the discipline of the market and creating a new moral hazard. The outcome being this rigged game known as a ‘global economy’ that we have to put up with today.

The Run Goes International

When World War II was winding down, the allied countries were meeting in Bretton Woods, New Hampshire to devise a new global finance system. What came out of the conferences was a plan where the US dollar, being backed by two-thirds of the world’s gold, would be used to settle international trades. Institutions such as the IMF and World Bank came out of the Bretton Wood Agreement to settle any balances of trade between participating nations. The need for foreign countries to have dollar reserves to transact globally cemented the US dollar as the world’s reserve currency. At certain times, foreign banks could convert their excess reserves back into gold at a fixed exchange rate of $35 per ounce.

Being the only currency backed by gold, made the dollar as good as gold. Other currencies were pegged to the dollar and then pyramided their national reserves upon their dollar reserves. So as the dollar inflated, the other pegged currencies inflated all the more to maintain the peg. The only brake on the rate of inflation was the fact that foreign banks could exchange their dollars for gold. As a sort of international fractional reserve banking system, a balance had to be struck between dollars and gold reserves.

During the 1960s, the Johnson administration set its mind on a “guns and butter” policy of warfare and welfare spending. Not to mention the capital-intensive space race. Perhaps the government hoped other nations wouldn’t notice or at least would not saying anything publicly, but the US government and Federal Reserve began inflating the dollar beyond its ability to be convertible into gold. There weren’t enough US gold reserves at the New York Fed or Ft. Knox to satisfy foreign demand. French President Charles de Gaulle wasn’t having it. What was considered in France as “America’s exorbitant privilege” de Gaulle saw how the rest of the Bretton Woods participants were paying the price for America’s inflationary policies. In 1965, he sent the French navy across the Atlantic to pick up their gold reserves and was followed by several other countries. The bank run took on an international flavor.

By 1971, President Nixon ended the convertibility of the dollar into gold and closed the international gold window. A quasi-international bank holiday, if you will. What was supposed to be a “temporary” solution to the ever disappearing gold supply, ushered in the era of a global fiat currency standard. What separated this “run” from previous bank runs was the absence of a lender of last resort. Who was there to bail out the US Federal Reserve?

Conclusion

Murray Rothbard once stated that the best defense for consumers against unscrupulous bankers was the bank run. For, the thought of a run sent shivers down the spine of any banker. It was up to depositors to do their due diligence and only bank with sound and transparent institutions. FDIC removed the need for any due diligence from the mind of consumers and gave birth to the era of ever riskier banking. The lesson to learn here is: “Whatever the government subsidizes, you get more of.” FDIC and central banking subsidizes speculative behavior and instills a false sense of security in the government’s ability to fix any and all problems.

The current global fiat currency regime is the by-product of this type of dangerous and speculative behavior. All nations are at fault, not just the imperial US dollar. The moment Nixon reneged on the dollar’s convertibility should have sent the world’s respective treasuries and banking institutions into action. They should have realigned their gold stores and made the attempt of reestablishing gold and silver as the international reserve standard. It was obvious the US couldn’t be entrusted with the job of maintaining the world’s reserve currency backed by a promise to tax her citizens. But it was easier to inflate, rather than raise taxes to pay for the ever increasing global welfare and warfare state. As long as foreign countries could pyramid their reserves on top of their dollar reserves, allowed for an easy inflationary policy at a global level. Some 40 years later it has reached utter ridiculousness.

The average lifespan of a fiat currency is around 30 to 40 years. But, the world has never been here before where the entire globe is on a fiat standard. How much longer can it last? Many a pundit and talking head has tried to predict the dollar’s demise, only to be pronounced as a “stopped clock”. As with any fiat standard, confidence is an essential element. This con game has many very powerful institutions at a global level behind it. Under normal economic conditions, this craziness should have ended long ago. But one thing still remains, as hard as they may fight against them, sooner or later the laws of economics will prevail.